Sputtering Euphoria -
The Spectre of Overvaluation

What passes for news is trite tis true.
For networks are cozy,
With outlooks as rosy,
As those expressed, by brokers and stokers.
Money men all,
Wax optimistic, while waving their wand.
A kaleidoscope of avarice,
Dances, through dusk and through dawn.

"What good," one may ask, "comes to those who would think?"
"When doomsters insist we're pushed to the brink?"
"When all we may need is just a stiff drink?"
"Al Greenspan is there, to save us our Butts,
Why dizzy our minds with talk of a rut?"

As boomers and bubbles alike there will mix,
Concoctions abrew which burble and hiss!

That all the world's a play,
This much we'll say -
For those who would doze,
Their curtain will close.

We are at a crossroads of extreme overvaluation. The present US market sentiment is one of sputtering euphoria. Last year alone the banking system created over $1 Trillion, an increase of more than 50% over the previous year. The invisible tide - a receding credit swell, has almost imperceptibly turned in the other direction.

World trade is sinking deeper into a morass, as beef, steel beams and bananas are but the beginning of a nasty international trade war, yet another reminder of how much we're sliding back into the 30's. The US trade imbalance, headed for $300 Billion this year, is yet another reminder of how much foreign credit has propped up our consumptive binges. On the political front, Clinton's popularity train has derailed as the Kosovo imbroglio is revealed as cover for his sustained domestic policy of "ethical endirtiment."

Investment is a funny animal. Undoubtedly there are sound fundamental reasons to choose a particular investment vehicle, based on relative risk and reward, which can be judged based on business outlook and historical returns. On the other hand, real money can be made in recognizing when a major imbalance exists, as when an investment becomes either extremely hot or cold. To a certain extent, there is only one reason to become involved in a hot investment - because everyone else seems to be investing in it, as reflected in its increasing price. Unfortunately the great majority of investors mistake such price behavior as evidence that the underlying vehicle has good fundamental value and is thus a compelling place for their money. This is probably the biggest investment trap of all. Buying into what appears to be a successful investment is usually a pitfall. There is no term in investment theory for this, so I'll dub it here: call it the "Illusion of the Rabbit." It is what gives direction and a further rationale for the herd instinct, another phenomenon in which the investor feels safer, with less perceived risk, when investing with the crowd. Herd instinct may well be called the "Illusion of the Warm Blanket." Together, this virulent duo forms a lethal wallop, because as the Rabbit provides an incentive to buy, the Blanket provides the motivation to hold what usually is an oversubscribed vehicle. This is exactly the very definition of a grand illusion in investing. However, by understanding this herd mechanism, one can clearly see the historic trends and how one can profit from them.

It is often said by the mainstream brokerage lore, that by owning a mutual fund you automatically diversify and that by putting your money to work with a competent professional who has time to make intelligent stock picks, one may realize the greatest reward at the lowest risk. What is overlooked is that these professionals, once they have established a successful track record, become magnets for the money that is to cause their downfall. The hugely successful mutual funds, the Magellans, must by necessity invest large sums of money in well-capitalized stocks, so as not to disturb the market adversely when trading. This necessarily leads to an involuntary institutionalized overvaluation. The biggest and most successful mutual funds are now as overvalued as the bloated stocks they're forced to buy. In effect mutual funds have by their very popularity, become investment vehicles for the ignorant masses to pump up the bluest of blue chips into the balloonist of overvalued balloons.

Equity markets have, in effect, become mutualized. It's estimated that a majority of stock is now held by mutual funds. This is higher than the last time institutional ownership was so prevalent, not suprisingly in the 1920's, when funds were called "Investments Trusts," a name unceremoniously dropped after 1929. The long growth spurt in the demand for paper assets has resulted in a complacent lot of investors. When history repeats, this flock will be fleeced.

Now its time to put your calculus hats on. There is a curious characteristic of equities. In the limit as a stock's dividend goes to zero, the stock converges to an adult baseball card. Business ownership doesn't mean much, since liquidation value is almost always next to zilch. The only added kicker is that you're able to vote for the All-Star Team once a season. Who can forget that dividend yields, averaging 5% over the previous two centuries, have recently shrunk to below 1%? That's a major league record.

The mania in stocks has also proliferated a breed of investor who's only in it for the short term, as accurately personified by the day trader. These internet intrepids are in a Mexican standoff with fingers nervously gripping the mouse pad, shooting glances at each other at an ever more frenzied pace. Even the average Jose has gotten into the action.

It is an old maxim, followed by the saaviest of Contrarian investors, that one should buy what everyone is selling and sell when everyone wants it. Applying this to today's environment should lead one to see why stocks are overvalued and that the most attractive opportunities are the ones most overlooked.

Take precious metals, for instance. I can't think of a more unpopular investment vehicle - and yet most everyone on the street will tell you gold and silver are an anachronism - irrelevant in this cashless world, as if gold were no longer a haven for financial difficulty or that financial difficulty has been legislated away. These are overblown sentiments. In contrast to objects like pet rocks, Beanie Babies, or bell bottoms, gold and silver are not tied (entirely at least) to ephemeral aesthetic trends. They are tied to physics, the search for permanence in life, the need for a reliable wealth storage medium, and the fundamental relationship between debtor and creditor. The popularity of gold over six millennia is due to the fact that there is no known substance which shares its unique physical attributes of divisibility, scarcity, and permanence. As a non-debt based asset, gold is the premier financial counterweight to a system built upon promises to make good on debt. This includes not only bonds and mortgages, but fractional reserve, credit in all its forms, and fiat money systems as well.

The tools of Wall Street are those that are built upon the Efficient Market Hypothesis or EMH, and its frankenchild Modern Portfolio Theory, or MPT. Their two key assumptions are that markets are liquid and investors are rational, neither of which is necessarily true at any given time, or for any given decision maker or market. Even Burt Malkiel, through successive editions of his popular "A Random Walk Down Wall Street," has become increasingly disenchanted with accepted models of risk, though he accepts the basic tenets of EMH. A thorough debunking of such myths as beta was dispensed by David Dreman's excellent books including "Psychology and the Stock Market" and "Contrarian Investment Strategies: The Next Generation."

Perhaps the longest dagger to pierce the body EMH is the existence of an anomaly which can't be explained in its tidy universe. This is Warren Buffet himself, a living EMH counterargument. In statistical jargon, he's a "six sigma event," or a person with a track record that is so utterly improbable that he can't exist in a mere population of 5 billion people. Speaking of Buffett, when asked just how expensive US companies were at the moment, Mr. Buffett replied: "Too expensive for me in virtually all cases." Anyone concerned about overvaluation should know that Warren has been a net seller of stock and a purchaser of silver last year. I'll play my cards the same way as the guy behind the mountain of chips, thank you.

EMH calls into mind another acronym, the "Emergency Medical Hologram." True believers will require the good doctor's service when their beloved assumptions break down, because he's about the only portfolio insurance available.

Myself, I'll opt for preventative medicine - I'll choose investments the crowd doesn't want.

Dr. Bob Dobbs
bob_dobbs@hotmail.com

Bob's Bombshelter Bear Page
http://www.jps.net/snowyang/MarketSavvy/Contrarian/contrarian.htm